Operating Cash Flow is the difference between the money collected from sales and the expenses paid for during the same period. That is, cash received, as opposed to sales made during the period, and outflow of the money used to run the business. Most small business owners are acutely aware of the difference between Sales (which is the same as Revenues) and Cash collected from Account Receivables. Other factors that impact Operating Cash Flow are just as straight forward, if often over looked.
Let’s walk through Operating Cash Flow for a very simple company – it sells widgets.
We are going to focus on the four months in the center of the six month period. To simplify things, the business is growing and we assume that all clients pay 30 days after their purchase. Most business owners are acutely aware of the Cash coming in, and those who survive and thrive put systems in place to ensure timely collection of their Receivables.
At this growing widget company, the average sale for the four month period is $1,950. Every client pays exactly 30 days after their purchase, so the average Cash received is for four month period is $1,725, or $225 per month less than Sales which occurred.
Incoming Cash for 5 months looks like this:
In this example, the owner has perfect foresight and only manufactures what will be sold the following month. His Cost of Goods Sold (COGS) is varies with the units sold (the number of widgets purchased by clients) and remains exactly 70% of the price of the goods and the small business owner has $500 per month in rent, utilities, and other fixed costs.
Break-even for this company occurs when monthly sales are above $1,667. That is, when sales are above $1,667, the firm shows a profit for the month. When Sales are below $1,667 for the month, the business is in the red and has a loss for the month – high enough to cover all of the firm’s costs and the firm reports a Profit. In the chart below, month 3 with sales of $2,500, shows a Profit of $250.
But in the real world, to sell widgets, this small business needs to have widgets on hand.
Assume that the widgets are manufactured and paid for prior to being sold. In this example, the widgets sold in month 3, to generate a profit, were paid for in month 2. In month 3, the owner had to pay for the production of the widgets that would be sold in month 4.
Operating Cash Flow for the period is shown below:
The widgets sold in month 3 are purchased and paid for in month 2. The cash received from the sale comes in month 4. Thus, while the company shows positive earnings of $250 on the month 3 P&L, Operating Flow is negative. The company’s cash flow from operations in the month is negative $120. This is due to 1) the costs associated with manufacturing widgets needed to sell in the following period AND 2) the delay in payments for the sales made during the month. Cash received in month 3 was from sales in month 2.
As you can see in month 4, positive cash flow occurs in the following month, when cash from sales in month 3 is collected from customers. In month 4, the strong sales in month 3 results in positive cash for the month of $460.
The key is managing inventory and payables. In this simplified example, the owner needs to make sure no month sees sales grow too fast. It is rare to find a small business owner willing to turn down higher revenues – but managing inventory levels and using vendor credit is a real option to help a growing enterprise.
Although this example is oversimplified, we hope it is more helpful than a textbook definition: Operating Cash Flow (OCF) is Cash flow from operating activities. It is the sum of net profit, depreciation, change in accruals, and change in accounts payable; minus change in accounts receivable; minus change in inventories. If consistently larger than profit, it is an indication that a company is building cash reserves or internal investment capacity.
Investopedia has good video on Operating Cash Flow.
Other good resources include:
Operating Cash Flow versus Net Income (ProfitGuard4.biz)
Cash Conversion Cycle and Cash Flow (FinancialSoft.biz)
For 25 years, Elizabeth Pearce has been a user of accounting information as a professional investor. For years, Pearce has been noticing how difficult it is many successful individuals to grasp nuances in numbers and has come to believe there is a biological component to this communication challenge. She is a Chartered Financial Analyst and holds an MBA from the Haas School of Business at University of California, Berkeley.